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Wednesday, October 10, 2012

The Rare Triumph of Diversifying with Bonds

There are good reasons for investors to reduce the riskiness of their portfolios using bonds. However, some commentators like to point out the surprising result that a portfolio mixing stocks and bonds can sometimes beat both the all-stock portfolio and the all-bond portfolio. A recent example is a post by The Reformed Broker titled ‘The Triumph of Diversification’. I ran an experiment that shows that this kind of reporting can set up investors for unrealistic expectations.

Common sense tells us that if you start your investing year with some stocks and some bonds and make no trades, your overall return will be somewhere between stock returns and bond returns. However, by a quirk of mathematics, if you rebalance to your target portfolio mix after each year, it is possible for your multi-year returns with a mixed portfolio to outperform both an all-stock portfolio and an all-bond portfolio. Somehow your portfolio can become better than the sum of its parts.

Out of the 33 ten-year periods, the 70/30 mix won out 4 times. In each case, average yearly stock and bond returns were within 1% of each other and the 70/30 mix won by less than 0.08%. So, while a mixed portfolio can beat both stocks and bonds, it happens infrequently and the edge tends to be very small.

None of this means that a mixed portfolio is bad. It’s just that you should be considering including bonds in your portfolio for the purpose of controlling risk rather than hoping to outperform an all-stock portfolio.

2 comments:

I agree that expecting a mix of stocks and bonds to outperform an all-stock portfolio is likely to result in disappointment.

According to the Libra data, Canadian bonds returned over 9.8% annualized from 1980 to 2011, approximately the same as stocks. That certainly has something to do with the result, and that seems unlikely to continue in the future.

That said, one of the principles of Modern Portfolio Theory is that you can lower the volatility of a stock portfolio by adding, say, 20% bonds without significantly lowering the expected return. Once you get into higher allocations than that, however, you should probably expect less.

@Spud: You're right that diversification works best when it involves assets that have low correlation but similar expected returns. However, when one asset class has a much lower expected return (like bonds do vs. stocks), the return bump from reduced volatility does not compensate for the the reduced expected return from including the lower-return asset. I think investors should focus on choosing the level of risk they can handle rather than hoping that including bonds will give greater returns.